Interest rate futures contracts, and in particular, Treasury futures, are contracts to sell or buy debt instruments, such as U.S. Treasury bonds or notes, at a future date. Anyone holding a position in an expiring Treasury futures contract during its delivery month must be prepared to fulfill the contractual obligation to deliver, or to take delivery of, the underlying deliverable grade Treasury securities, discussed in more detail below. For this reason, delivery on contract—or the prospect of it—may be considered the chief determinant of prices at which Treasury futures trade.
Presently, the Treasury futures complex is neither intended nor organized to serve as a primary marketplace for the transfer of ownership of cash Treasury securities. Yet, the ever-present possibility of transfer via physical delivery means that futures contract prices are inextricably linked to cash market prices. Thus, physical delivery into Treasury futures may be considered, at once, infrequent yet pivotal.
Hedgers—those who use Treasury futures chiefly to lay off interest rate risk exposure rather than to acquire it—are seldom interested in using futures as a means of transacting Treasury securities. For this reason, hedgers typically liquidate their outstanding futures positions before the contracts enter their delivery cycle.
The majority of such liquidations are rolled. That is, the liquidating trades in the expiring contract are combined with trades that initiate corresponding new positions in the next following (or “deferred”) contract delivery month. For example, a market participant with an outstanding long position in an expiring futures contract would sell it, netting the position to zero. Simultaneously, the trader would establish a new long position in the deferred contract, equivalent in scale to the position in the expiring contract that the trader has just liquidated.
The practice of rolling is prevalent. Accordingly, only a small share of Treasury futures held by market participants may result in physical delivery—historically, around 3.6 percent. For the same reason, an expiring Treasury futures contract's open interest tends to have shrunk by half by the time the contract's physical delivery cycle commences.
The terms and conditions for each Treasury futures contract specify its deliverable grade, i.e., the securities that a short position holder may deliver at contract expiration for sale to a long position holder to fulfill the delivery obligation. These deliverable grade securities—Treasury notes and bonds—are debt instruments backed by the full faith and credit of the U.S. government. Under the current rules, any Treasury security may be tendered for delivery, as long as it meets the futures contract's criteria for delivery suitability. Typically, several securities are eligible and, from one contract expiry to the next, their number may vary with the frequency of issuance of notes and bonds by the U.S. Treasury.
For example, regarding Long Term U.S. Treasury Bond Futures, according to rule 40101.A. of the Chicago Board of Trade Rulebook, “[t]he contract grade for delivery on futures made under these Rules shall be U.S. Treasury fixed principal bonds which have fixed semi-annual coupon payments, and which have a remaining term to maturity of at least 25 years. For the purpose of determining a U.S. Treasury security's eligibility for contract grade, its remaining term to maturity shall be calculated from the first day of the contract's named month of expiration, and shall be rounded down to the nearest three-month increment (e.g., 12 years 5 months 18 days shall be taken to be 12 years 3 months). New issues of U.S. Treasury securities that satisfy the standards in this Rule shall be added to the contract grade as they are issued. Notwithstanding the foregoing, the Exchange shall have the right to exclude any new issue from the contract grade or to further limit outstanding issues from the contract grade.”
Further, with respect to Long Term U.S. Treasury Bond Futures, according to rule 40101.B. of the Chicago Board of Trade Rulebook, “[e]ach individual contract lot that is delivered must be composed of one and only one contract grade Treasury bond issue. The amount at which the short Clearing Member making delivery shall invoice the long Clearing Member taking delivery of said securities (Rule 40105.A.) shall be determined as:Invoice Amount=($1000×P×c)+Accrued Interest
where                P is the contract daily settlement price on the day that the short Clearing Member gives the Clearing House notice of intention to deliver (Rule 40104.A.). P shall be expressed in points and fractions of points with par on the basis of 100 points (Rule 40102.C.); and        c is a conversion factor equal to the price at which a security with the same time to maturity as said security (as per Rule 40101.A.), and with the same coupon rate as said security, and with par on the basis of one (1) point, will yield 6% per annum according to conversion factor tables prepared and published by the Exchange.        
For each individual contract lot that is delivered, the product expression ($1000×P×c) shall be rounded to the nearest cent, with half-cents rounded up to the nearest cent. Example: Assume that P is 100 and 25/32nds. Assume that c is 0.9633. The product expression ($1000×P×c) is found to be $97,082.578125. The rounded amount that enters into determination of the Invoice Amount is $97,082.58. In the determination of the Invoice Amount for each individual contract lot being delivered, Accrued Interest shall be charged to the long Clearing Member taking delivery by the short Clearing Member making delivery, in accordance with 31 CFR Part 306—General Regulations Governing U.S. Securities, Subpart E—Interest.”
Regarding short term U.S. Treasury Note Futures, according to rule 21101.A. of the Chicago Board of Trade Rulebook, “[t]he contract grade for delivery on futures made under these Rules shall be U.S. Treasury fixed-principal notes which have fixed semi-annual coupon payments, and which have:                (a) an original term to maturity (i.e., term to maturity at issue) of not more than 5 years 3 months; and        (b) a remaining term to maturity of not more than 2 years; and        (c) a remaining term to maturity of not less than 1 year 9 months.        
For the purpose of determining a U.S. Treasury note's eligibility for contract grade, its remaining term to maturity shall be calculated from the first day of the contract's named month of expiration, and shall be rounded down to the nearest one-month increment (e.g., 1 year 10 months 17 days shall be taken to be 1 year 10 months). New issues of U.S. Treasury notes that satisfy the standards in this Rule shall be added to the contract grade as they are issued. If the U.S. Treasury Department auctions and issues a Treasury security that meets these standards, such that said security is a re-opening of an extant Treasury issue that had not previously met these standards, then the extant Treasury issue shall be deemed to be a Treasury note meeting these standards and shall be added to the contract grade as of the issue date of said newly auctioned Treasury security. Notwithstanding the foregoing, the Exchange shall have the right to exclude any new issue from the contract grade or to further limit outstanding issues from the contract grade.”
Further, with respect to short term U.S. Treasury Note Futures, according to rule 21101.B of the Chicago Board of Trade Rulebook, “[e]ach individual contract lot that is delivered must be composed of one and only one contract grade Treasury note issue. The amount at which the short Clearing Member making delivery shall invoice the long Clearing Member taking delivery of said notes (Rule 21105.A.) shall be determined as:Invoice Amount=($2000×P×c)+Accrued Interest
where                P is the contract daily settlement price on the day that the short Clearing Member gives the Clearing House notice of intention to deliver (Rule 21104.A.). P shall be expressed in points and fractions of points with par on the basis of 100 points (Rule 21102.C.); and        c is a conversion factor equal to the price at which a note with the same time to maturity as said note, and with the same coupon rate as said note, and with par on the basis of one (1) point, will yield 6% per annum according to conversion factor tables prepared and published by the Exchange.        
For each individual contract lot that is delivered, the product expression ($2000×P×c) shall be rounded to the nearest cent, with half-cents rounded up to the nearest cent. Example: Assume that P is 100 and 25.5/32nds. Assume that c is 0.9633. The product expression ($2000×P×c) is found to be $194,195.26259375. The rounded amount that enters into determination of the Invoice Amount is $194,195.26. In the determination n of the Invoice Amount for each individual contract lot being delivered, Accrued Interest shall be charged to the long Clearing Member taking delivery by the short Clearing Member making delivery, in accordance with 31 CFR Part 306—General Regulations Governing U.S. Securities, Subpart E—Interest.”
With respect to Treasury Note and Bond futures listed for trading on the Chicago Board of Trade, updated U.S. Treasury conversion factors are periodically published by the Exchange, which have historically been based upon an 8% or 6% yield.